Agency costs and structural inefficiency in state owned enterprises | Sunday Observer

Agency costs and structural inefficiency in state owned enterprises

Sri Lankan Airlines which has accumulated losses running into US$1 billion and a negative net worth, continues to operate; with funding from state banks.  Pic: Courtesy
Sri Lankan Airlines which has accumulated losses running into US$1 billion and a negative net worth, continues to operate; with funding from state banks. Pic: Courtesy

The problem of agency, also called the principal-agent problem is encountered in any enterprise, private or public that is not directly managed by its owners. The divergence of interests between owners and managers result in substantial costs to owners. The mitigation of agency costs is dependent on the effectiveness of corporate governance mechanisms present.

State enterprises suffer agency costs and political costs, therefore, ceteris paribus, for state enterprises to function effectively, the regime of governance needs to be much stronger than for private entities. In Sri Lanka, the governance regime is a lot weaker, leading to under-performance and abuse.

Defining the problem

The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. In business, the agency problem usually refers to a conflict of interest between a company’s management and the company’s shareholders.

The shareholders, the ultimate owners of the company, as principals, elect the management to act and take decisions on their behalf. The managers are supposed to employ the resources of the business in a manner that will maximise shareholder wealth.

The managers’ best interest, however, is to divert these resources to enhance their personal status (through perquisites such as chauffeured limousines, business-class travel) and maximise their own wealth (through excessive pay or corruption).

An example may be seen in recent news reports: a payment of Rs. 75m to senior managers of the People’s Bank and allegedly excessive payments to top management of SriLankan Airlines.

Another instance, in a leading PLC, where the auditors were dismissed when they insisted that disclosure was necessary with regard to a bungalow that was being used by key management personnel.

Later, a shareholder of the company moved to convene an EGM to call explanation from the directors with regard to “disappearance of a Rs. 2.5 million cheque in favour of a Mahesh Gajanayake and about directors’ remuneration over and above the limit set out in the company’s Article 107.”

The reduction of agency costs is regarded as an essential function of company law and corporate governance.

The problem in state enterprises: Political costs and agency costs: State ownership creates its own agency problems, which are caused by the separation of the politicians and bureaucrats who oversee SOEs from ‘the citizens’ on whose behalf the enterprises are ostensibly owned. This creates an extra level of agency.

SOEs are ultimately owned by citizens but run by managers who are controlled by politicians. Politicians determine or otherwise influence the appointment of key management and must hold the managers accountable.

Unlike shareholders, the politicians have not invested their money in the business. As they have no stake there is no particular interest in ensuring it is well run. Politicians, however, have incentives to direct SOEs to achieve economically inefficient objectives for political purposes, giving rise to political costs. These may be benign, if policies enhance social welfare, even if they fail to maximise shareholder value but more often they are malign, favouring political allies at the expense of public welfare.

The real owners, the citizens, have no voice, and little interest, in how the business is run.

Citizens as shareholders

Citizens are the ultimate ‘owners’ but cannot exert any meaningful oversight as: they have no legal standing as owners; the fragmented nature of the ‘ownership’ creates a collective action problem: no one citizen, even ones who are seriously interested, has an incentive to bear the costs to monitor the managers.

Oversight is costly, time and effort must be spent monitoring performance if malpractice is to be detected, a task made more difficult as citizens lack ready access to information. As no direct rewards accrue to a diligent citizen from such action there is little incentive to expend the effort do so; they will depend on politicians to this. As discussed previously, the politician has no incentive to do so.

The main mechanisms to address these two layers of agency costs are general corporate laws, on the one hand, and general political and legal institutions, on the other, but for reasons discussed later they are weak.

Agency problem

Therefore, the performance of state-owned enterprises (SOEs) suffers from political costs (i.e. the costs associated with control of firms by politicians who have political goals that differ from economic efficiency) and agency costs (i.e. the costs resulting from managerial pursuit of private benefits at the expense of the firm), leading to chronic inefficiency and under-performance.

The agency problem is present in all corporate entities but it is important to note a fundamental distinction between private shareholders and citizens.

Investors in private companies take a risk when they put money down, but it is one taken of their own volition. Shareholders subscribe voluntarily to shares; they are not compelled to invest. Generally people invest in private companies only if they know and trust the management.

If the business does not perform to expectations they will earn a lower return. If it fails the shareholders will lose, but it is their own money, voluntarily invested that is lost.

With SOEs the important difference is that unlike in a company where willing investors are taking a conscious decision, the investment in an SOE is by citizens who contribute involuntarily and unwittingly. Taxation is compulsory and in the form of indirect taxation, all citizens contribute to SOEs.

In the most extreme case, if shareholders are disgusted and can find no remedy they still enjoy a final option: exit. They may sell their shares. For citizens, unless they choose to migrate, there is no exit option.


Businesses must risk their own money when they go into trade, but governments risk other people’s money. If a business does not earn a profit, the owner will need to keep infusing funds and this provides a powerful incentive to improve efficiency. If the owner is incapable of improving the business and is unable to infuse more funds, a mismanaged business will eventually close.

SOEs, however, enjoy implicit state guarantees and funding via state banks which undermines even the threat of bankruptcy as a source of managerial discipline.

The continuous accumulation of losses is only possible because of this factor. An example is Sri Lankan Airlines which has accumulated losses of US$1 billion and a negative net worth, continues to operate; with funding from state banks. For context, the current IMF facility is US$1.5 billion.

The problem of agency within the political context of Sri Lanka: As citizens lack the interest or wherewithal to monitor SOEs, efficiency is entirely dependent on the system of governance. Distorted incentives and weakened mechanisms present structural challenges to efficiency.

Politics in Sri Lanka is based on patronage. Ministers face pressur from constituents for jobs or favours. State sector jobs are especially prized for status and security. Politicians believe that granting jobs is a condition for re-election. In general, lawmakers and ministers in Sri Lanka across party lines and ideological divides, view SOEs as providing avenues to create employment.

SOEs incorporated as limited liability companies enjoy greater autonomy in the management of their affairs allowing the minister to bypass Treasury or budget restrictions placed on recruitment. This leads to problems of over-staffing. The more staff are hired, the greater the potential votes, leading to the chronic over-staffing evident in many SOEs.

The allied problem is nepotism – the recruitment of people based on relationships instead of ability. Recruiting unsuitable candidates weakens the general level of competence within the SOE which adversely impacts performance.

In the case of the state banks it is possible for the minister to exercise patronage by directing lending on preferred terms to selected constituents.

Therefore, patronage is particularly harmful as it has a dual impact on performance; the hiring of excess staff adds to unnecessary costs while nepotism leads to diminished efficiency.

The problem is pervasive. The Secretary to the Treasury, Dr. Samaratunga noted that recruitment to SOEs take place without the approval of Management Services Department (MSD) of the Treasury.

“All SOEs across the government — public corporations, statutory board or government-owned companies — have effected recruitment without proper approval of the MSD.


Corruption is endemic in the political system of Sri Lanka. The root of the problem lies in campaign finance.

Changes in the 1978 Constitution removed limits on campaign spending and the need to disclose sources of funding.

This has lead to a massive increase in spending with candidates seeking to outspend each other to win. Those who succeed come into office having either made major investments or incurred significant debts, usually a combination of both. This creates an in-built incentive for corruption.

In the absence of strong governance mechanisms, it is hardly surprising if MPs do not succumb to temptation; spending a good deal of their time in office either recovering election spending or raising funds for their next re-election campaign.

This explains the scramble for positions in government that allow control over resources. The greater autonomy of SOEs make them particularly tempting targets. Some appear to have been formed largely to facilitate corruption.

Case study: Lanka Coal Company

The company was incorporated as a subsidiary of the CEB to handle procurement of coal. The commercial rationale to incorporate a separate legal entity, with the associated statutory and administrative costs, to manage procurement instead of following the standard procurement process of the CEB, seems weak.

A special investigation by the Auditor General details numerous weaknesses in procurement at Lanka Coal resulting in an estimated loss of Rs. 4 bn from 2009-16. (following a COPE inquiry the company has since adopted the government tender procedure).


The Secretary to the Treasury has noted that SOEs have a “general lack of governance practices, lack of accountability mechanisms, issues associated with lack of clear policy and legal frameworks and weak supervisory roles played by the management and board of directors”. Accountability for SOEs must be exercised by Parliament, particularly the Committee on Public Enterprises but both were weak although the recent 19th Amendment has strengthened COPE.

Parliament not a check on government

The proportional representation system where voters elect a party (rather than an MP) leaves MPs dependent on party leaders for positions. Defying the party line could mean expulsion and loss of office which means they have no incentive to question the party line. The system of crossovers allows the ruling party to form a comfortable rubber stamp majority.

Parliament, therefore, no longer functions effectively as a check on Government.

Weak committees

Much of the important work of Parliament takes place in committees, which examine issues in detail, most important is the Committee on Public Accounts (COPA) and Committee on Public Enterprise (COPE) which scrutinise expenditure. Until recently they were ‘Consultative Committees’ chaired by a Minister and structured to aid the executive than hold it to account. With recent reforms these are now known as ‘Oversight Committees’ chaired by an opposition MP and their function is better geared to scrutiny and accountability.

However, the committees by their own admission are under-resourced lacking equipment and access to specialised skills such as legal advice. A culture of scrutiny also needs to develop and their proper functioning is dependent on the technical capacities of the MPs that populate them.

Lack of a comprehensive SOE corporate governance framework: Many countries have adopted comprehensive Corporate Governance practices to strengthen the governing bodies that oversee and control (Shareholders or Owner Meetings, Board and Management, internal monitoring structures) while defining clear rules of engagement between the different actors and increase the transparency and accountability towards the stakeholders. These are lacking in Sri Lanka and overall system of governance still seems inadequate to hold SOEs to account. The perverse incentives and weak governance greatly increase the political and agency costs of state enterprises. It is, therefore, not surprising that a study by a Senior Lecturer at the University of Colombo, Dr. Lalithasiri Gunaruwan found that “inefficiency is a common feature in all Sri Lankan SOEs, across all organisational categories.”

Greater efficiency can only be expected through better governance, addressing the fundamental weaknesses in the political system and adopting a comprehensive system of corporate governance for State enterprises.